The Brexit market carnage may not be over

Some market commentary since Friday’s market cataclysm triggered by the result of the British referendum on Europe has focused on how assets have only re-adjusted to roughly the point they were before the vote.

It’s the no-dramas thesis: the Brexit sell-off – which saw stocks fall and bonds rally around the world – was only really about everyone getting over their excitement in thinking Britain would vote to stay in Europe.

Futures for the FTSE 100, the British stocks benchmark, blasted through 6300 points before the vote but then plummeted around 10% when the count was underway, before recovering strongly in active trade on Friday in Britain, finishing just over 6% down for the day.

The comeback came at the start of trade in London, as Bank of England governor Mark Carney hit the TV screens to assure the world that the BoE was “well prepared” and he would “not hesitate to take additional measures” to ensure stability.

So there is some thinking – and it feels logical – that risk assets, especially global stock indices, are simply back to where they were before the euphoria of an apparent Remain result from Britain was in play.

So given that stocks have been near record highs, there’s not much to worry about, right?

Not so fast.

Many investment banks, economists, and hedge fund managers say there will be an immediate impact on British GDP. The estimates of the drag impact range between half a percent and 1.5% over the coming financial year for the UK economy. And the impact of this may still need to be absorbed by the markets, according to Andrew Sheets, Morgan Stanley’s chief cross-asset strategist.

With the British pound having closed at $1.37 on Friday, Sheets wrote in a note to clients (my emphasis added):

Financial markets discount years of expected impact in an instant. And on Friday, sharp one-day declines spoke volumes about the long-term risks created by the UK’s vote to leave the EU. GBP fell to its lowest level against USD since 1985. Shares of large UK banks lost nearly a fifth of their value. The EURO STOXX 50 had its biggest one-day loss since 1987. UK and German interest rates sank to historical lows, reflecting expectations of a hit to both UK and eurozone growth for years to come.

Unfortunately, this discounting process may not be finished. Our FX strategists believe that GBP will ultimately fall to 1.25-1.30. Our equity strategists believe that European and UK stocks may need to correct a further 7-10% over the next several months. While these adjustments may seem harsh in light of Friday’s moves, we think they’re consistent with the uncertainty this vote has created. 1.25-1.30 for GBP would only begin to make the currency look cheap on a trade-weighted basis. A further 7-10% fall in UK and European stocks would simply bring forward multiples down to the long-run average. Both seem reasonable in light of increased uncertainty.

And that uncertainty is high and extended, given that leaving the EU is a two-year process under the Treaty of Lisbon. This is likely to delay investment, and will hit consumption if consumers feel less confident about the economic situation or the value of their home. While the size of the economic impact depends on the political steps taken from here, our economists estimate that it could knock 1.5pp off UK GDP over the next 18 months. This impact is not limited to the UK. After considering the impacts to trade, confidence and investment, they see a potential cost of 0.8pp to euro area GDP. For the global economy, there could be a cumulative hit of ~0.5pp from our baseline between now and the end of 2017. This weakening of the global environment would likely weigh on the Fed’s thinking. Our US economists no longer expect the Federal Reserve to raise rates this year, keeping G4 yields lower for longer.

If you think the market jolt on Friday was just about fixing for the Leave vote and that everything should be fine from here, there’s a bit more to consider.

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